It was bound to happen, a bank getting caught red-handed trading derivatives like it was a reunion of 2007 risk traders. But that it was JPMorgan Chase that found itself under the bare light bulb of significant “risk-on” derivatives losses is a true surprise.
Luminary Chairman and CEO Jamie Dimon did his best to navigate the controversy as an honest mistake: “Admit it, fix it, and move on — it is part of the normal process of hedging firm risks.”
He was no doubt hoping that would be the end of it. Yet, more than a few will want to know how “hedging” losses can wipe out 1 percent of this firm’s capital in a few short weeks and erase $11 billion in market cap in minutes. Not very reassuring when one considers that JPM and many banking firms of lesser reputation are putting taxpayer dollars at risk every day.
The disclosure coincides with the recent filing of the firm’s 10-Q and amounts to what is called a “Type II subsequent event.” The Wall Street Journal reported that the trades came from the bank’s Chief Investment Office, which the Journal notes is responsible for managing the firm’s risk.
“The bank, betting on a continued economic recovery with a complex web of trades tied to the values of corporate bonds, was hit hard when prices moved against it starting last month, causing losses in many of its derivatives positions. The losses occurred while J.P. Morgan tried to scale back that trade.”
I’m no trader, but that sounds more like a proprietary trade than a hedge. A legitimate hedge is intended to offset potential losses in a cash position, not create a loss on its own. And if the hedging instrument creates a loss, it is typically offset by a gain in the cash instrument.
It is possible that the instrument they used to hedge was a poor match for the position being hedged. In that case, one wonders just how often the global leaders in over-the-counter (OTC) derivatives simply outsmart themselves in the structured market. We can think of more than a few who are no longer around to tell us.
More troubling is the potential that the Chief Investment Office took it upon itself to take a proprietary position on the direction of the market. Indeed, the Journal quoted Dimon as saying that the hedging strategy was “flawed, complex, poorly reviewed, poorly executed and poorly monitored,” suggesting something was askew in the trades. That is precisely what a properly calibrated Volcker Rule is designed to prevent.
Regardless, the $2 billion write-off is but 1 percent of the $190 billion the bank reported as equity in its just-released first quarter 10Q. Dimon also noted that the bank would still earn around $4 billion for the quarter, versus $5.4 billion last quarter.
But JPMorgan is damn good at this — they’ve been leaders in this market since the mid-1990s. Even they suffer from a continued lapse in oversight and strategy. That raises concerns about all the other firms, both in the United States and elsewhere, with less experience, weaker controls, and weaker financials. Once again, this is the point of the Volcker Rule — to prevent banks from putting bank capital, insured deposits, and taxpayer funds at risk to support bad trades.
The JPMorgan mess highlights another problem, as well: the difficulty in distinguishing prop trading from other legitimate and permitted activities. In this case it was hedging, but there also are concerns with market making. When CFA Institute wrote its letter to U.S. regulators otherwise supporting the idea of the Volcker Rule, we expressed concern about its implementation, due to difficulties distinguishing prop trading from legitimate market making, particularly in the fixed-income markets. Rather than ban market making, we suggested moving such activities to a separately structured and capitalized broker/dealer affiliate, and insulate (ring-fence in the parlance of the Vickers Report) the bank — and taxpayers — from such trading activities.
For the banking industry, this news couldn’t come at a worse time in its battle against implementation of the Volcker Rule. The odds were that something like this was going to happen eventually. That it happened now, and to JPMorgan, only makes their arguments for a lighter-touch Volcker Rule more hollow.
For taxpayers, on the other hand, the circumstances might be opportune.